Is Cyprus small enough to fail without bringing the euro crashing down?

By threatening to pull the plug on Cypriot banks, the European Central Bank
has pushed Cyprus to make up its mind, an ultimatum that might break the
single currency.

'Cyprus only represents 0.2pc of European GDP and following the ECB’s big bazooka pledge to intervene to shore up sovereign bonds in the event of market contagion there is confidence that the island is small enough to fail.'Photo: Reuters

The International Monetary Fund, the ECB and European Commission will not pay a euro cent in aid (or liquidity) to Nicosia unless Cyprus deals with its broken banks.

Cypriot MPs and the government have shied away from this, rejecting the haircut on depositors that follows from a one-off levy to raise €6bn or by creating a “bad bank” for the shaky assets of Laiki and the Bank of Cyprus.

It might be democracy but as the Greek crisis has shown, the eurozone has little patience with mere MPs or voters.

Without restructuring Cypriot banks, which necessarily means inflicting huge losses on depositors and Russia, the troika of the IMF, ECB and commission will not free-up the €10bn Cyprus needs to make it through next week.

The eurozone side point out that the Cypriot financial sector has a paper value eight times the GDP of Cyprus and that any rescue package must not go over 100pc of the island’s wealth, around €17bn.

Without dealing with this, the argument goes, led by the IMF, the eurozone will be throwing good money away after bad. The spiralling cost of Greek debt, from €65bn to €240bn within two years, has been a bitter lesson.

On the other side, Cyprus is keenly aware that if it wipes out foreign deposits – the big ones rather than the 60,000 smaller British savers – then it kisses goodbye to being the offshore banking haven that has attracted tens of billions of investment from Russia, Lebanon and Israel.

The point is also made, legitimately, that Cypriot banks took a hit of over €4bn for the team when the eurozone wrote off debts in Greece.

But eurozone patience is running out, with a saga that began a year ago at the height of the debt crisis, and now Germany, perhaps with the ECB, is now confident the EU single currency can survive Cyprus collapsing.

Cyprus only represents 0.2pc of European GDP and following the ECB’s big bazooka pledge to intervene to shore up sovereign bonds in the event of market contagion there is confidence that the island is small enough to fail.

The writing might be on wall after a telephone conference of eurozone finance ministries on Wednesday night, a get together boycotted by Cyprus.

During the meeting there was “open talk” of Cyprus leaving the euro and the imposition of capital controls to prevent runs on banks, presumably intended across southern Europe.

Here lies a risk, bank failure in Cyprus (and the clearly hollow promise of deposit guarantees that can be overridden by levies and are only as good as the sovereign state that makes them) could spark contagion.

The cure of capital controls could be as bad as the disease as credit flows stop, a scenario compounded if Cyprus leaves the euro. Can the euro survive if Cyprus leaves? That is the now question. It is another existential moment for the EU's single currency.